Breaking a mortgage can be costly as rates fall. How to lessen the penalty

This article is part of Global News’ Home School series, which provides Canadians the basics they need to know about the housing market that were not taught in school.

The Bank of Canada’s oversized interest rate cut this week might have some Canadian homeowners locked into costly mortgages fantasizing about a more affordable rate.

Shubha Dasgupta, CEO of Pineapple Mortgage, says that after years of homeowners renewing into higher rates as the central bank hiked its policy rate, he foresees an uptick in broken mortgages as Canadians seek a better deal with lower rates materializing.

“You’re probably going to see a lot of Canadians breaking their mortgages mid-term that have secured higher rates over the last couple of years,” he tells Global News.

“Taking advantage of the current market conditions, break their mortgage and get into a lower interest rate.”

But the prospect of moving to a new home with a cheaper rate, or refinancing to take advantage of lower monthly payments, comes alongside the daunting penalties that come with breaking a mortgage.

While breaking a mortgage can often rack up thousands of dollars in penalties depending on the type and years left on the term, experts who spoke to Global News say there are some options to mitigate or even avoid those fees entirely.

Breaking a mortgage boils down to exiting the contract with a lender before the maturity date — cutting a five-year mortgage term short after two years, for example.

Victor Tran, mortgage and real estate expert at Rates.ca, says the most common situation for breaking a mortgage revolves around selling a property.

The other typical circumstance is a refinancing arrangement, wherein a homeowner might want to pull out equity they’ve already paid into a property or break the current term to take advantage of lower rates in the market.

Breaking a mortgage can also happen due to more personal circumstances, like the end of a marriage, where one or both individuals on the mortgage want to be removed from the property title or sell the home for a fresh start.

Once a mortgage is broken, lenders will usually levy a penalty.

Penalties are fairly straightforward for variable-rate mortgages, though there’s some variation between lenders and the specifics of the contract. But usually, the penalty is equal to three months’ worth of interest, based on either the prime rate or the contract rate.

For fixed-rate mortgages, which are the more common style in Canada, penalties can get more complicated — particularly in a declining interest rate environment like today.

Breaking a fixed mortgage will see a lender levy a penalty worth three months’ interest or a calculation called the interest rate differential (IRD), whichever is higher. When rates are falling, the IRD is more likely to come into play.

When the Bank of Canada lowers its policy rate and mortgage rates fall as a result, Tran says that lenders don’t want to see borrowers break their contract and refinance, because they’re losing out on their interest payments at the higher rates for the rest of the term.

He gives the example of a homeowner locked into a five-year fixed term at 6.25 per cent deciding to break the contract after two years to take advantage of a new 4.25 per cent rate in the market.

“What the lender is saying is … ‘We’re basically losing out on two per cent for the next few years. So because of that, we’re going to charge you that penalty and we’re going to recoup our losses,’” Tran explains.

The IRD is calculated by taking the difference in interest you’d pay over your remaining term between your current contracted rate and the new rates on offer in the market. If there’s a sizable drop in rates between when a homeowner signed the mortgage and when they’re considering breaking it, Tran says the penalty is going to be “a lot larger,” particularly if there are many years left before renewal.

There are a number of calculators online, including on the websites of many of Canada’s big banks, that can help to give an estimate of what the penalty might be if you were to break your mortgage.

But Dasgupta notes that because of the simplicity of the three months’ interest penalty, opting for a variable mortgage can offer “a lot more flexibility.”

Canadian households that are likely to break a mortgage, perhaps because they’ve got a growing family and know they will need to move in the next couple of years, might benefit from this option when renewing or taking out a mortgage, he says.

However, variable mortgages can also come with restrictions that prevent them from being ported. Restrictions on porting vary from lender to lender.

But common situations like moving homes or refinancing need not come with substantial penalties.

For those buying a new home and selling their old property, Tran says it’s common for a lender to allow the owner to port their existing mortgage from one home to the next.

This means the remaining term length, amortization and total amount of the mortgage will remain the same, but the owner will have to requalify for the loan based on the specifics of the new property and accounting for any changes in the household’s financial picture.

That option works for those who don’t need to take out a larger loan to finance the move. But for someone buying a larger home, the lender could offer a “blended” rate that combines the existing mortgage terms with additional financing at today’s rate, Tran explains.

In a simple example, say an individual has an outstanding mortgage of $150,000 with an interest rate of six per cent, and wishes to refinance to add an additional $150,000 at today’s rates of four per cent. The lender may then offer a blended rate of five per cent on the total $300,000 mortgage. This would also forgo any penalty for breaking the existing contract.

While the renewal date will usually stay the same for a blended mortgage, the amortization may extend if the borrower needs a longer time horizon to pay back the larger loan.

A similar “blend-and-extend” option exists for those wanting to refinance and add onto their current term with a mix of today’s rate. Such an option might see a lender offer a new five-year term blending the old rate for the remaining original term with a new rate on the additional months.

Tran says while porting is common, a lender may also offer to discharge the old mortgage and start on a “clean slate” with a new loan at today’s rates, sometimes waiving the penalty as the borrower is keeping their business with the same bank.

In the case of a marital breakdown, if there’s no new money being borrowed, a lender may levy just an administrative charge for a spousal payout or a change in title, Tran says.

There are some other options to mitigate the impact of a penalty.

In the case of breaking a mortgage and switching to a new lender, Tran says the incoming lender might be willing to add up to $3,000 to the total mortgage loan to offset the impact of a penalty. In this way, the pain of paying some of that penalty is spread out over the life of the mortgage rather than a sudden shock upfront.

Some lenders will also offer cashback rewards or certain bonuses for borrowers willing to switch, which can also lessen the pain of a penalty.

Dasgupta notes that for households that have extra money on hand before they know they’re about to break a mortgage, using those funds on a pre-payment can help to reduce the overall penalty they’ll soon face.

“For example, if you were to pay your principal down by 15 per cent, you could then reduce your penalty cost by the same,” he explains.

For Canadians keen to take advantage of lower interest rates in a refinancing deal, Tran warns that the penalty isn’t the only factor to consider.

Even if the upfront payment shock from the penalty is worth it over the long term to save money on the remaining term, he notes that there are other costs that come with setting up a new mortgage: legal and appraisal fees, title insurance and going through the process of requalifying from scratch.

“It’s basically going to the whole nine yards again,” he says. “And some people will do that as long as it makes sense. So short-term pain for long-term gain.”